# Demographic Divergence and Safe Asset Scarcity

## Abstract

Population aging increases demand for safe assets while the supply of safe sovereign debt — concentrated in a few AAA-rated economies — grows only with the fiscal capacity of those same aging issuers. We bridge the demographic–current account literature with the Caballero–Farhi–Gourinchas safe asset framework using a 237-country panel (1990–2024). We find: (1) demographics depress safe sovereign yields ($Z_1$ ≈ 43.7**, 10-year bonds) but the effect concentrates among safe-rated issuers; (2) aging countries tilt portfolios toward debt over equity and disproportionately allocate to safe-rated destinations; (3) global safe supply relative to demographic demand has declined secularly, compressing convenience yield proxies; (4) bilateral gravity estimates confirm safe-seeking — the demographic distance effect is stronger when the destination holds AA- or above rating; (5) forward projections show a widening "safe asset gap" through 2050, as demographic demand accelerates while several current safe issuers face downgrade risk from fiscal pressure. The paradox is self-reinforcing: aging raises safe asset demand while simultaneously undermining the fiscal foundations of safe asset supply.

## 1. Introduction

The global decline in safe real interest rates is one of the defining macroeconomic puzzles of the past three decades. A growing literature attributes this partly to population aging (Kopecky and Taylor, 2022; Lisack et al., 2017; Carvalho et al., 2016), which increases the share of wealth holders relative to income earners, raising the desired saving rate and depressing equilibrium interest rates. Separately, Caballero, Farhi, and Gourinchas (2008, 2017) argue that a shortage of safe assets — assets that serve as stores of value in all states of the world — depresses safe rates specifically, creating a "safety premium" or convenience yield.

These two literatures have developed largely in parallel. We bridge them by asking: does population aging affect interest rates specifically through the safe asset channel? The Kopecky-Taylor "murder-suicide" finding — that demographics depress safe rates but not risky returns — is exactly what the safe asset scarcity framework would predict if aging disproportionately increases demand for safe assets.

Our contribution is threefold. First, we decompose the demographic effect on interest rates into a general level effect and a safety-specific component. Second, we test whether aging countries allocate portfolios disproportionately toward safe assets, using both aggregate portfolio composition and bilateral CPIS data. Third, we construct a supply-demand framework for safe assets with demographic demand and sovereign supply, projecting the "safe asset gap" through 2050.

## 2. Literature and Hypotheses

### 2.1 Demographics and Interest Rates

Kopecky and Taylor (2022) show that demographic structure — summarized by a polynomial $Z_1$, $Z_2$, $Z_3$ in the age distribution — predicts sovereign bond yields but not equity returns. This "murder-suicide" pattern is consistent with lifecycle saving theory: aging populations save more in safe assets, depressing safe returns, while the growth slowdown that accompanies aging reduces the marginal product of capital.

### 2.2 Safe Asset Scarcity

Caballero, Farhi, and Gourinchas (2008, 2017) formalize the idea that the supply of safe assets — sovereign debt of highly rated governments, plus some private label securities — has not kept pace with global wealth accumulation. When demand for safe assets exceeds supply, the convenience yield (the premium investors pay for safety) rises, depressing safe rates below what fundamentals would imply.

Gorton (2017) and Krishnamurthy and Vissing-Jorgensen (2012) provide evidence that US Treasuries carry a substantial convenience premium, and that this premium varies with the supply of Treasuries outstanding. He, Krishnamurthy, and Milbradt (2019) model the paradoxical relationship between sovereign debt levels and safety: more debt from a safe issuer can be safer when demand is high, up to a tipping point.

### 2.3 Our Hypotheses

**H1: Portfolio tilt.** Aging populations allocate a larger share of external assets to debt (vs equity) and specifically to safe-rated sovereign issuers.

**H2: Rate decomposition.** The demographic effect on interest rates loads primarily on safe sovereign yields and convenience yield proxies, not on general risk-free rates.

**H3: Bilateral safe-seeking.** In gravity models, the demographic distance effect on portfolio flows is amplified when the destination is a safe-rated sovereign.

**H4: Supply-demand paradox.** Aging safe issuers face mounting fiscal pressure (from our fiscal dominance paper) that threatens their safety status, even as demographic demand props up their bond prices. The safe asset gap widens as demand grows and supply is threatened.

## 3. Data and Methodology

### 3.1 Panel Construction

We use a 237-country panel spanning 1990–2024, combining data from:

- **Demographics**: UN World Population Prospects 2024 medium variant. We use the Koomen–Imhof demographic polynomial ($Z_1$, $Z_2$, $Z_3$) plus old-age and youth dependency ratios.
- **Bond yields**: 10-year government bond yields and 3-month short rates for 23 OECD countries (IMF IFS).
- **External positions**: Lane–Milesi-Ferretti External Wealth of Nations — gross debt assets, equity assets, FDI, reserves.
- **Bilateral portfolio flows**: IMF CPIS bilateral portfolio debt and equity positions.
- **Sovereign ratings**: S&P long-term foreign currency ratings, compiled from Kose et al. (World Bank). We define *safe issuer* as AA- or above (time-varying).
- **Fiscal data**: Government debt/GDP, revenue, expenditure from IMF WEO.

### 3.2 Key Variables

**Safe issuer dummy**: $\text{safe}_{it} = \mathbb{1}[\text{S\&P rating}_{it} \geq \text{AA-}]$. This is time-varying: countries enter and exit safe status based on rating actions.

**Debt share**: $\text{debt\_share}_{it} = \text{debt\_assets}_{it} / \text{gross\_assets}_{it}$. Measures portfolio tilt toward bonds vs equities.

**Safe share**: Fraction of country $i$'s bilateral debt assets allocated to safe-rated destinations, computed from CPIS bilateral positions.

**Convenience yield proxy**: Lending rate minus government bond yield (corporate-sovereign spread). For the US, this proxies the Krishnamurthy–Vissing-Jorgensen convenience yield.

**Safe supply ratio**: GDP-weighted government debt of safe-rated issuers divided by global GDP.

### 3.3 Estimation

We use pooled GLS with AR(1) error correction following the EBA methodology, consistent with our companion papers. The baseline specification is:

$$y_{it} = \beta_1 Z_{1,it} + \beta_2 Z_{2,it} + \beta_3 Z_{3,it} + \gamma' X_{it} + u_{it}$$

where $X_{it}$ includes GDP growth, inflation, fiscal balance/GDP, capital account openness (KAOPEN), and lagged NFA/GDP. For bilateral gravity models, we use bilateral demographic distance $\Delta Z_{k} = Z_{k,i} - Z_{k,j}$ plus standard gravity controls.

## 4. Results

### 4.1 Rate Decomposition

We replicate the Kopecky-Taylor baseline: $Z_1$ significantly predicts 10-year real bond yields ($Z_1$ ≈ 43.7**, Table 2). The critical new finding is that this effect **concentrates among safe-rated issuers**. When we split the sample, safe issuers show a stronger demographic effect on yields than non-safe countries. The $Z \times \text{safe}$ interaction is significant, confirming that demographics load on the safety premium specifically.

For sovereign spreads (country yield minus world average), demographics have the expected sign for non-safe countries: aging compresses spreads, consistent with aging EM economies appearing more creditworthy. The convenience yield proxy (lending-government spread) also responds to demographics, consistent with the Caballero-Farhi-Gourinchas prediction.

See Table 2 for full rate decomposition results.

### 4.2 Portfolio Allocation

Aging countries tilt portfolios toward debt: $Z_1$ significantly predicts the debt share of gross external assets (Table 3). This is stronger for OECD countries, consistent with deeper financial markets enabling portfolio rebalancing. The KAOPEN interaction suggests that financially open aging countries tilt more toward debt.

The safe share measure — fraction of bilateral debt allocated to safe-rated destinations — also responds to demographics. Aging origin countries allocate disproportionately to safe destinations, even controlling for gravity variables.

### 4.3 Supply-Demand Dynamics

The global safe supply ratio (safe issuer debt / global GDP) has not kept pace with the demographic demand proxy (GDP-weighted global OADR). When safe supply is included as a regressor alongside demographics, both remain significant (Table 4), suggesting they capture different aspects of the rate decline.

For safe issuers specifically, we find the fiscal paradox: aging drives up government expenditure faster than revenue (replicating our fiscal dominance findings for this subsample), threatening the fiscal sustainability that underpins safe status. The He-Krishnamurthy-Milbradt channel is operative: safe issuer debt × demographics interactions show that more debt is tolerated when demographic demand is high, but this tolerance has limits.

### 4.4 Bilateral Gravity: Safe-Seeking

In bilateral gravity regressions (Table 5), adding a $\Delta Z \times \text{dest\_safe}$ interaction confirms safe-seeking behavior. When origin countries are more aged relative to their destination, portfolio debt flows are larger — and this effect is amplified when the destination is a safe-rated sovereign.

Critically, this safe-seeking effect appears for debt flows but not equity flows, consistent with the Kopecky-Taylor murder-suicide: aging drives demand for safe bonds specifically, not for risky assets. The result is robust to excluding financial centers and controlling for bilateral rate differentials.

### 4.5 Projections

Forward projections using UN WPP 2024 demographics (Table 6, Figure 1) show the safe asset gap widening through 2050. Global demographic demand (GDP-weighted OADR) rises monotonically, while safe supply grows only if current safe issuers maintain their ratings while expanding debt.

Several current safe issuers face downgrade risk from demographic fiscal pressure (Table 6b). Japan has already lost its AAA status; France and the UK were downgraded below AA-. Finland, Austria, and Korea face aging pressures that could compress their fiscal space.

## 5. Discussion

### 5.1 The Self-Reinforcing Paradox

Our findings reveal a self-reinforcing dynamic at the heart of the safe asset market:

1. Aging increases demand for safe assets (portfolio tilt, bilateral safe-seeking)
2. This demand props up safe sovereign bond prices (rate depression)
3. But aging simultaneously pressures the fiscal capacity of safe issuers (expenditure-revenue asymmetry)
4. Fiscal pressure threatens the safety status of these issuers
5. Any downgrade reduces the supply of safe assets, further widening the gap

This is the "supply-demand paradox": the very demographic force that creates demand for safe assets is also the force that threatens to destroy the supply.

### 5.2 Connection to Companion Papers

This paper bridges several strands of our research program:

- **Asset returns** (Paper 5): We explain *why* demographics affect safe rates but not equity returns — it is a safe asset demand channel, not a general interest rate channel.
- **Fiscal dominance** (Paper 8): The expenditure-revenue asymmetry for safe issuers is the supply-side threat. Aging safe issuers face a fiscal reckoning that could trigger downgrade cascades.
- **Net/gross** (Paper 14): The income balance dominance finding is consistent with safe asset flows: most of the CA adjustment operates through returns on existing positions (predominantly safe debt), not through trade.
- **Bilateral gravity** (Paper 15): The safe-seeking channel adds a new dimension to bilateral portfolio allocation beyond what demographic distance alone captures.

### 5.3 Policy Implications

The safe asset gap has implications for:

- **Monetary policy**: Safe asset scarcity contributes to the effective lower bound constraint. Central bank balance sheet policies (QE) substitute for safe asset supply.
- **Fiscal policy**: Safe issuers face a paradox — markets demand more safe debt, but fiscal sustainability requires less. The "exorbitant privilege" from safe status may erode precisely when it is most needed.
- **International financial architecture**: The concentration of safe assets in a few sovereigns creates systemic fragility. Proposals for global safe assets (e.g., eurozone safe bonds, SDR-denominated instruments) become more urgent as demographic pressures mount.

## 6. Conclusion

Demographic aging is both the primary driver of safe asset demand and the primary threat to safe asset supply. This paper documents four new findings: (1) the demographic rate effect concentrates among safe-rated issuers; (2) aging countries actively tilt portfolios toward safe assets; (3) bilateral flows exhibit safe-seeking behavior; and (4) the safe asset gap is projected to widen through 2050. The Caballero-Farhi-Gourinchas framework, combined with demographic dynamics, predicts a future of secular safe rate depression punctuated by potential sovereign downgrades — a "safe asset trap" from which aging economies may struggle to escape.

## References

See references.bib for full bibliography.
